Third, a convenient unit of account should be chosen. This may be the unit of currency
in which returns from the project are measured. Both the returns and cost of funds should
be expressed in the same currency.
Fourth, the MNC should take into account the likelihood of changes in constraints, such
as borrowing restrictions, tariff and exchange controls, limitations on cash transfers and
other remittances, taxes and so on. Given the objective of the management to borrow at
the lowest possible effective rate, the finance managers of international firms should
explore the possibilities of raising funds in various financial markets/currencies.
Fifth, in the event of the firm needing more funds than available through retained
earnings, it is to raise funds from external sources (say, debt, preference shares and
equity). The cost of each of these three sources varies. In general, debt is regarded the
cheapest source of finance as interest on debt is tax deductible.
As the debt ratio rises, debt holders rightly perceive higher debt/equity (D/E) ratio as
more risky for their lendings.
For the same reason the credit rating firms may reduce its credit rating. From the equity
shareholders’ perspective as well, financial risk will also increase their required rate of
return. Therefore, it is apparent that debt should be used only within safe limits.
Sixth, the entire advantage of a cheap source of finance, say debt (assuming to have been
used within safe limits), should not go to one project only which happens to be financed
from that source. Likewise, one single project only which not be burdened with the
costly source of finance, say equity. Issuing equity ‘now’ implies potential of raising
debt in future years; issue of debt ‘today’ implies the virtual necessity to go for equity in
future years. Therefore, it is only appropriate and logical, that the firm should use
weighted average cost of these sources as a discount rate for investment decisions.
The cost of capital of multinational enterprises (like domestic corporate firms) is ideally
based on weighted average cost of long-term sources of finance. Its overall
determination, therefore, requires separate computations of each major long-term source
of finance, namely, long-term debt, preference shares, equity and retained earnings.
Determination of cost of various sources of finance is simplified, to a marked extent, by
adopting the Porterfield approach of explicit and implicit costs. According to Porterfield,
“The explicit cost of any source of capital is the discount rate that equates the present
value of the cash inflows that are incremental to the taking of the financing opportunity
with the present value of its incremental cash outflows”.
In the context of international finance, cash flows should be duly adjusted for taxes,
foreign exchange risk, timing of repatriation and so on.